Friday, February 12th, 2021

Tickets to the Moon

“Small Caps to the Moon” is the sort of headline which makes nervous investors think that it’s time to leave the party. Our research suggests that small cap outperformance is not a particularly reliable indicator of equity market peaks. For the US, it worked in March 2000, and April 2002, but it gave a disastrous false positive in November 2003 and was completely silent about the 2008 crash. The evidence has continued to be mixed since then.

Timing the index is not really the point of this article. We want to highlight the fact that Small Caps are #1 in both the US and in Europe – which doesn’t happen very often – and to work out how we got here and what happens next. Our models currently recommend an overweight of 67% in the US and 63% in Europe, a three-year high in both cases. The US all-time high was 89% in April 2002, but the recommendation typically peaks at about 75%, so there may not be much further to go. However, sectors can continue to outperform after our recommendation has peaked – just with lower momentum or less risk-efficiency.

The outlook for European Small Caps is more bullish. The typical peak is around 90% overweight and it very rarely peaks below 75%, so we have high confidence that this rally will continue (subject to all the usual pandemic caveats). The main reason for the difference between the US and Europe is the relative performance and weight of the Tech sector in each index.

So much for the outlook. The more interesting question is how to identify these rallies before they get going. Is there any way of using our own data to get ahead of our recommendation? Regular readers will know that we look at many other indicators besides the simple recommended weight. One of our favourites is identifying the moment when this breaks above or below its 26-week moving average (MAV). This enabled us to identify the Small Cap rally in Europe and the US in June; so it may be helpful to review the evidence for this indicator.

In the last 25 years, there have been 950 occasions in the US where the recommended weight for a sector has crossed its MAV (850 in Europe). If you had bought or sold, as appropriate, and then held the position until the opposite crossover, your average outperformance per trade would be 1.2% in the US and 1.6% in Europe. The average holding period is 11 weeks in the US and 12 weeks in Europe, giving annualised outperformance of 5.4% and 7.3% respectively. This is before we apply any stop-loss limits or profit maximisation strategies. This is a very simple test, which highlights the fact that it is possible to get ahead of the curve on selected buy and sell recommendations. The Small Cap trades in both regions are good examples of this. Others, which have worked well, include buying Financials in September and Industrials in August, or selling Staples and Utilities in November.

Looking to the future, it is one of the reasons why we are watching Energy so carefully. It broke above its MAV in both regions in November and is still well above it, despite some recent profit-taking. So, if you missed the Small Cap rally and are searching for the next possible ticket to the Moon, don’t ignore the oil patch.

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